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David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures. Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions. Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

Thirteen Macroeconomic Musings

There are three great economic distortions in our world today that will eventually have to be unwound. All of them are temporarily self-reinforcing, so they will persist until something breaks. Here they are:

Recycling the US current account deficit.

Too much speculation in leveraged credit markets.

Too much speculation from private equity investors.

I could add a fourth, willingness of institutions to invest in weakly funded structures, like hedge funds, and anything else with liquid liabilities and illiquid assets, but that is for another day. Tonight, I want to focus primarily on the first of those issues, the consequences of the US current account deficit. Here goes:

Almost all bond managers love positive carry. It is the lure of free money, and it works most of the time. Borrow cheaply and invest the money in something that yields more. That simple idea lies behind most of the excesses in our debt markets globally, and fuels the three excesses listed above. With currencies, market player borrow in yen and Swiss francs, and invest in higher yielding currencies like the New Zealand Dollar. Even major corporations like Citigroup borrow in yen, because the rates are low.

When a country sends more goods to the US than it receives back, there is a natural inflationary effect. The local population buys goods and services, not US bonds, yet as banks accumulate the bonds, considering them to be part of their reserves, the balance sheets of the banks expand, because increased capital allows them to make more loans, which adds to the buying power of individuals and corporation, and can lead to more inflation. To resist the inflation, a country can let its currency rise versus the dollar, making exports less competitive, and increasing the willingness to import. This has happened in Thailand, India, and South Korea. Once this happens in enough nations, interest rates will rise in the US. We will send more goods to balance the accounts, and fewer bonds.

Thinking about inflation, wages are rising in China, particularly for those that work in export-oriented sectors. That is leading to rising prices for exports to the US. That will eventually have an upward impact on US price inflation.

Now, inflation is not a serious concern yet in Japan or Switzerland. But if it did become an issue, the carry trade would end rapidly. Interest rates would be forced up rapidly, and the cost of loans denominated in those currencies would rise as well, making the borrowing uneconomic. Personally, I think the yen is 20% undervalued; in a few years, the yen will correct, if not more.

Now, imbalances are not forever. The emerging markets ten years ago were fragile because they ran current account deficits. Today many of them have the high quality problem of surpluses (and the inflation they can engender). They are in a stronger position to deal with crises. The US, though is does not know it yet, is ina weaker position to deal with crises.

On the “dark matter” debate, my position has been that the US has a big debt to the rest of the world, but that since the US invests in higher yielding investments abroad than foreigners do in the US, until recently, the US earned more from foreign investments than foreigners earned off of US investments. This WSJ blog post supports my contention. On net, the US contains risk-takers, and the returns have been good so far, but the foreign debt has become so great, that the added yield is not enough to keep up with what we have to pay out.

The main thing that could go wrong here would be a trade war. Now, one of those is not imminent, but the Doha round at the WTO has not been a success, and there is pressure in many nations to restrict trade, or foreign ownership of assets. If one wants to destroy the gains from trade, that would be the way to go.

The 10-year Treasury yield has gotten jumpy in this environment, closing the week out at 5.18%. I would expect the yield to muddle between 4.75 and 5.50% through the remainder of the year. This is a finely balanced environment, with reason for rates to rise and fall. Thus I expect the muddle.

Finally, three bits on debt and demographics. The first is an article from the Wall Street Journal on how insurers are going after Baby Boomers. This is just another factor in the yield seeking that I have been talking about. Baby boomers want yield from their assets so that they can enjoy their retirement. That yield-seeking is and will be a major force distorting the markets for years to come. It is much easier to demand more yield from your assets than to save more. In the long run, it is much harder to realize more yield from your assets than it is to save more.

Don’t trust US Government estimates of the deficit; instead, look at the change in net liabilities, the way a corporation might do it. That would balloon the paltry $250 billion deficit to $1.3 trillion. I have been writing about this since 1992. The US government will not make good on all the promises it has made in money with today’s purchasing power. The tipping point is not here yet for when this becomes obvious, but I believe it will become clear within the next ten years. Pity the next three presidents.

Partly as a result of this, and greater labor competition from abroad, we are finally seeing some evidence that the current generation of young adults is not doing as well as their parents did. This may be a case of increasing income inequality, so that the average can increase while the median decreases. From my angle in society, this is happening. A few motivated people are prospering, and many are muddling along. Where my opinion differs here is that people are generally getting what they deserve; in a more competitive world, people have to compete harder than their parents did, in order to do better. In general, people are not working harder, and so their results are falling behind those of their parents on an inflation adjusted basis.

Not to leave it on a down note, but that’s it for the evening. Hope to write cheerier stuff next week.

About David Merkel

David J. Merkel, CFA, FSA, is a leading commentator at the excellent investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited David to write for the site, and write he does — on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, and more. His specialty is looking at the interlinkages in the markets in order to understand individual markets better.
David is also presently a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. He also manages the internal profit sharing and charitable endowment monies of the firm.
Prior to joining Hovde in 2003, Merkel managed corporate bonds for Dwight Asset Management. In 1998, he joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.
His background as a life actuary has given David a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that David will deal with in this blog.
Merkel holds bachelor’s and master’s degrees from Johns Hopkins University. In his spare time, he takes care of his eight children with his wonderful wife Ruth. View all posts by David Merkel →